Where are the opportunities in Chinese equities?

Is China due a hard landing?

Chinese equities continue to face scrutiny from investors as some say optimism about the progress made in the US-China trade dispute has helped investor sentiment, while others worry a so-called ‘hard landing’ in China is imminent and portfolio exposure should be kept to a minimum.

There is no question that economic growth in China, and globally, is slowing.

Chinese GDP slowed to 6.4 per cent in the fourth quarter of 2018, the weakest quarterly growth figure since the global financial crisis in 2008, according to data from the National Bureau of Statistics of China, published on January 21.

But Michelle Qi, chief investment officer of Eastspring Investments’ wholly foreign-owned enterprise in China, says the quality and sustainability of China’s economic development, rather than the speed of its growth, should be the key focus for investors this year.

Ms Qi explains: “China doesn’t need to grow 9 or 10 per cent every year, 6 per cent is still very quick, and there's a lot more opportunity for stockpickers like ourselves – you just need to check the right sector and the right names.”

As many clients’ portfolios continue to have some Chinese equity exposure, it is important to know what key challenges and opportunities lie ahead for the market in 2019.

US-China trade spat

Amit Mehta, director for emerging markets at Hermes Investment Management, explains that over the course of 2018, China’s relationship with the US took a marked turn for the worse and the ongoing trade conflict, coupled with a slowing Chinese economy, led to a sell-off in Chinese equities in the second half of the year.

Mr Mehta explains: “But trade tensions should ease in 2019 as a compromise is reached, and a trade compromise should be good for world markets, including China’s, especially if it is accompanied by sufficient [government] stimulus to get the economy back on its 6 per cent plus growth track.”

Indeed, US President Donald Trump and Chinese President Xi Jinping set March 2 as a deadline to strike a more comprehensive agreement, after calling a truce to their trade war at the G20 summit in Buenos Aires in December 2018.

Nevertheless, Mr Mehta says it is important to recognise that the US-China relationship has now fundamentally changed from one of cooperation to one of competition.

He continues: “The US has belatedly recognised that its economic ‘little brother’ has serious aspirations to global leadership, and is in the process of withdrawing many of the facilitating conventions (academia, technology, and military capability, etc) that have been in place for decades.

“We are at the early stages of a geopolitical competition that will eventually turn more serious, and infinitely more complex, than the Cold War with the Soviet Union.”

Similarly, Ms Qi says China’s economic slowdown can be attributed to “the trade dispute – not so much on earnings but rather on investor sentiment – and the second, more direct impact, China’s deleveraging campaign”.

She adds: “The deleveraging process of China’s balance sheets actually hit the economic growth quite hard from the second half of 2018, and that’s why we've seen a decline in GDP growth since – and [we expect] the bottom out will take place until the second quarter into the third quarter this year.”

The trade spat comes at an especially difficult time for the Chinese economy, suggests Claudia Calich, manager of the M&G Emerging Markets Bond fund.

Ms Calich notes: “As the cost-benefit of additional policy stimulus is lower than it was a decade ago, given the higher leverage in the system – inflation is good to cut debt but comes at a very high competitiveness cost.”

Adviser views

Despite the negative headlines, she warns investors should not rule out any potential positive tailwind, as the US-China relationship could stabilise and have a positive impact on asset prices, including emerging market debt.

However, Philip Hanley, director and independent financial adviser at Philip James Financial Services, believes “the news of China’s financial death has been greatly exaggerated”.

Mr Hanley suggests: “All will be well until the next ‘crisis’ in a couple of years from which lots of people, mainly in China, will make lots of money.

“It’s a dictatorship, they can do and tell us they’re doing whatever they want.”

Despite his reservations, Mr Hanley says he invests in model portfolios and multi-asset funds and would expect most portfolio managers to maintain exposure to “one of the world’s largest economies”.

While Dennis Hall, chief executive and chartered financial planner at Yellowtail Financial Planning, warns investors should approach with a little more caution, as the level of debt in China draws some parallels to Japan in the early 1990s.

He asks: “Why would you want to get involved, other than through a global equity fund which would ensure you’re not going overweight, and which would give better exposure to companies already benefiting from China through trade?”

Outlook for 2019

The Chinese economy is now on a par with the US as a key driver of global financial markets, and investors need to follow it closely, suggests James Dowey, chief investment officer and chief economist at Neptune Investment Management.

Mr Dowey adds: “Allocation wise, despite China’s economic ascendency, I’m sceptical that Chinese stocks will prove as reliable a mechanism as US stocks to grow one’s wealth over the long term.

“The problem is that shareholders are possibly just not powerful enough in China to win so big a share of the proceeds of long-run economic growth, so I believe one should temper one’s allocation to Chinese stocks to take account of this problem.”

But Danny Dolan, managing director of China Post Global, believes that despite the slowdown, China’s growth continues to strongly outperform other major markets.

“It is unsurprising that headline growth is slowing, with the ongoing rebalancing of the economy towards services, and tightening fiscal policy, credit conditions and financial supervision,” he observes.

He also believes setting a lower growth target for 2019 – between 6 per cent to 6.5 per cent – as well as China’s recent stimulus plans, in light of slowing growth and the ongoing US tariff dispute, was the right move by Chinese authorities.

Mr Amit predicts GDP growth will slow to 6.2 per cent, because “given likely tariff increases and residual effects from the slowdown in shadow lending and municipal property sales, a mid to high single-digit growth is realistic”.

He also suggests the Chinese economy “normally responds well to government stimulus”, and this time should be no exception.

“This may be one of the last times, however, that the government can use this trick as the country’s level of debt is high, its level of technology is low, and its political system is sclerotic,” Mr Amit notes.

“With all this in mind, we believe the equity market in China is undervalued, and is, over the medium term, quite capable of performing strongly.”

Short-term support

Roger Jones, head of equities at London & Capital, disagrees and explains that investing in a Chinese equity fund, as opposed to a global equity fund, could be a good idea in the short term.

Mr Jones explains: “Short-term support for Chinese equities is not hard to find, with low valuations, improving trading war relations and the recent government stimulus likely to boost or support GDP growth.”

Mr Jones continues: “Chinese equity returns have varied dramatically from global equities over the last few years and global equities are very US stock market dominated.

“[But] China is now the second largest economy in the world and the largest contributor to global GDP growth.”

Eastspring Investments’ Ms Qi says, looking at historical valuations, China A-shares also look cheap.

She notes that foreign ownership of China A-shares is already about 6.5 per cent, and this could go up as a result of the inclusion of China A-shares in the MSCI Global indices in 2018.

Nevertheless, she warns: “While it’s an opportunity for any China manager, the important thing is to talk to an onshore manager who lives in China, who talks to Chinese companies and grows with them every day.

“We prefer to look at industry leaders who will benefit from strong market pricing power, the recent supply-side reforms and increased deleveraging, and also higher environmental standards.”

Separately, she notes: “While a trade war is negative on the import and export sector, it has been positive in the way it pushed the government to think about changing to domestic-driven income policy – China can grow quite strongly based on domestic demands.”

Momentum

While the outlook at the start of 2019 has proved to be more positive, Adrian Lowcock, head of personal investing at Willis Owen, says: “Going forward will be about managing expectations and avoiding panic, valuations, falling markets etc, more than anything else.”

Mr Lowcock identifies three Chinese equity funds to watch in 2019:

• First State Greater China Growth fund
• Fidelity China Focus fund
• Janus Henderson China Opportunities fund

He also signposts two sectors investors in China should keep an eye on in particular, including technology and insurance.

Mr Lowcock explains: “There are concerns over regulation of technology. However, in China, the state is all and personal liberties are less of a concern, so regulation is likely to be less onerous in Chinese technology companies.”

He adds: “The country has also invested heavily in developing expertise in these areas and that sort of investment, and the momentum it creates doesn’t turn off overnight.”

victoria.ticha@ft.com